Revenues of $28.2 billion lagged consensus by a bit, but comps finally looked decent. Meanwhile, margin improvement helped to drive a welcome, three-cent EPS beat.
Credit: Supermarket News
Solid second quarter
For the first time in the past five quarters (i.e. since I started taking shots at projecting quarter-by-quarter revenues), Kroger finally managed to match my identical sales expectations that were set at 2.2% ahead of earnings day. The metric, in fact, was the highest delivered since 1Q16.
Top-line strength seems to have come primarily from Kroger's private brands, as I had been expecting, which were up 3.1% YOY vs. 3.3% last quarter. The revenue mix shift towards these products is likely to continue, as Kroger keeps introducing upwards of 200 new items per quarter to its "Our Brands" lineup. As a lateral trade idea, the trend away from branded products at supermarkets should bode ill for consumer packaged food companies, especially those with a more fragile and U.S.-centric business model - Kraft Heinz (KHC) quickly comes to mind.
Source: DM Martins Research, using data from multiple company reports
The next encouraging development came in the form of margin resilience. Fuel-adjusted FIFO margin contraction of only 29 bps was the least severe since 1Q18 (see chart below), and the number could have been better if not for low levels of profitability in the faster-growing pharmacy segment. As the digital channel gains scale, margins have been improving on that end of the business as well.
Some benefits from the supermarket chain's Restock Kroger transformation program could be seen further down the P&L. SG&A as a percentage of revenues decreased slightly, with the upside to profits being credited to "administrative efficiencies, store productivity and sourcing cost reductions". In the end, adjusted EPS grew by a healthy 7.4% YOY despite tax headwinds, supported in great part by the encouraging margin trends.
Source: DM Martins Research, using data from company reports
But Kroger is not out of the dog house yet
While Kroger's 2Q19 results were mostly a "hit", the preliminary outlook for 2020 was largely a "miss". The two short sentences that defined the uncertainties about the next few quarters were delivered by CEO Rodney McMullen, during the company's earnings call:
We want to be clear on today's call that we are not reconfirming the three-year $400 million in incremental operating profit expectation. In November, we will give detailed 2020 annual guidance.
To Wells Fargo's (WFC) analyst Ed Kelly's point regarding the now-dated 2020 operating profit targets, "no one thought [Kroger was] going to get there" anyway. The problem with pulling guidance without a more elaborate conversation around it is that investors may now have little confidence in next-year earnings estimates (growth of a bit over 6%) being realistic. And when uncertainty rises, valuations tend to fall.
This is one of the problems that I have had with KR over the past few months. The company is undergoing a deep transformation process that, as I anticipated, has been a bit messy and slow-moving. Comp improvement finally seems to have reached a better cadence, but arguably, a few quarters later than originally expected. Profitability has been improving, but possibly not enough yet to instill confidence in shareholders. Op margin of about 2.0% is still razor-thin, and cost, pricing or revenue mix headwinds could have a noticeable (negative) impact on the bottom line.
Still, a good portfolio diversification tool
In order to turn bullish on KR, I still need to see more from the Cincinnati-based company. Therefore, I maintain my "neutral" stance on the stock that reflects a balance of (1) concerns over the fundamentals of the business and the ultimate benefits that the Restock Kroger program can produce, and (2) appreciation for the defensive nature of the stock, which could have a desirable diversification effect in a balanced equities portfolio.
KR's valuation multiples continue to look a bit richer - current-year P/E of 12.0x vs. less than 10.0x only six weeks ago. But the stock's price may be a fair one to pay, considering how much better shares are likely to endure a hypothetical period of macroeconomic deterioration in the future.
I do not yet own KR because I believe I can create superior risk-adjusted returns in the long run using a different strategy. To dig deeper into how I have built a risk-diversified portfolio designed and back-tested to generate market-like returns with lower risk, join my Storm-Resistant Growth group. Take advantage of the 14-day free trial, read all the content written to date and get immediate access to the community.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in KR over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.